POSTED VERSUS EFFECTIVE SPREADS - GOOD PRICES OR BAD QUOTES

When trades are executed inside the posted bid-ask spread, the posted spread is no longer an accurate measure of transactions costs faced by investors. Using two samples of market orders, one based on orders su bmitted by retail brokers and one based on orders submitted electronic ally to the NYSE, we document a significant difference between the pos ted spread and the effective spread paid by investors. For most orders , the effective spread averages half the posted spread. In addition, w hen the posted spread widens, only 10 to 22% of the increase appears i n the effective spread. These results have significant implications fo r any empirical work that uses the posted spread as a measure of the c ost of trading. Our findings also document a significant difference in the expected execution price across exchanges. This finding is robust to controls for the type of order, and implies that U.S. equity marke ts are not completely integrated.